Morningstar: We See a 16% Return in the S&P 500's Future

[raylopez99]

Note the cost of capital used is 10%, about the same as the 4+6%=10%
given in this newsgroup.

RL

We See a 16% Return in the S&P 500's Future

Why we think the SPDR is poised to rip off a double-digit gain.

By Jeffrey Ptak, CFA, CPA | 02-01-08 | 02:00 PM | E-mail Article |
Print Article | Permissions/Reprints | Jeffrey's Monthly Newsletter

Let's cut right to the chase: Our research suggests that SPDRs Trust
(SPY), an ETF that tracks the S&P 500 Index, will return 16%
annualized over the next three years.

Lest you wonder which hat we pulled that number out of, rest assured
that there were no wands or seers involved. And because top-down macro
forecasting isn't our bag (what...you were expecting the second coming
of Bill Gross?), we kept the focus squarely on the stocks in front of
us.

As it turns out, that's a lot of stocks--we cover 2,000 companies,
including more than 450 of the S&P 500's constituent holdings.
Therefore, we can harness the work that our analysts do in evaluating
company fundamentals, such as the presence and durability of
competitive advantages each business might boast. That work culminates
in a fair value estimate that our analysts place on each stock they
cover. We can roll up the fair value estimates that our analysts have
placed on the S&P 500's holdings and, voilà!, come up with a fair
value estimate for the index as a whole (roughly 1,600 as of Jan. 31).

But how does that get us to an expected return? We ordinarily expect a
stock's price to converge to fair value over a three-year time
horizon. Assuming that we compound our fair value estimate at the cost
of equity--which is the minimum compensation that we demand for owning
a stock--the expected return represents the return that will cause the
stock's price to converge to fair value at some point in the future,
not to exceed three years. This same math holds for an index like the
S&P 500, provided we have adequate coverage of its underlying assets
(the 450 S&P 500 stocks that we cover account for 99.5% of the index's
assets).

Consider then that the S&P 500 was trading at a 15% discount to our
fair value estimate as of Feb. 1 and that our weighted-average cost of
equity for the index stands at roughly 10%. When you take the two
together, it translates to a 15.89% expected return for the S&P 500.
Subtract the SPDR's infinitesimal 0.09% expense ratio from that tally,
and you end up with a 15.8% return.

Of course, a cushy return does not a screaming buy make. Otherwise,
we'd throw caution to the wind and buy nothing but very risky stocks
such as biotechs. That's why we have to consider SPDR's return in
relation to its risk.

The verdict? We'd recommend the fund at these levels, as investors
stand to reap a hefty 5.7% excess return (the difference between
SPDR's 15.8% expected return and its 10.1% cost of equity). Put
differently, investors can buy a security that's less than half as
volatile as our typical below-average-risk stock at 85 cents on the
dollar. We'd take that trade.

[JOSE BAILEN]

Thanks. Also, given that 2007 was a bad year for micro and small cap
stocks -which average negative returns for the year as a whole- and
the overperformance of these stocks over the long term, for a long
term investor there is an additional reason to invest in these types
of stocks...